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Winning the NPA Battle: A Game Theory Perspective

The NPA issue with the Indian PSU banks have been hogging the limelight for some time and there seems to be no easy out. The recent NPA ordinance is said to have added more teeth to the regulator & the banks to crack whip on the large defaulters and have raised some hope of seeing an end to this. But will it work? What are the strategic options for the banks & the defaulters and is there a dominant strategy for them? We will discuss that in the light of our applying the concept of Game Theory to this problem of NPA.

For those who are not in knowledge of this theory, may refer to the book ‘Thinking Strategically’ by Avinash K. Dixit and Barry Nalebuff. We would not try to explain the theory here as the author(s) are not knowledgeable enough to explain the concept. We will take a simplistic view in our case to share the thoughts and the possible outcomes.

  1. The players: They are the PSU banks and the other are the large-medium corporates who have defaulted in their debt
  2. The strategic options:
  3. PSU Banks: Options are 1. Continue normal process (discuss, restructure etc.) and 2. Invoke Insolvency/ Bankruptcy proceedings
  4. Defaulting Corporates: Options are 1. Stall (basically don’t pay up) and 2. Pay & resolve

So how each of the options measures up? For us let’s use the following most commonly used Game Theory framework.

X & Y are the payoffs to the to the Banks & the corporates respectively. To illustrate, let us assume that bank strategy is to continue with normal NPA resolution process while the corporates strategy will be to stall it. Under these strategic choices, the payoff for the banks is X1 while for the defaulting corporates is Y1

Estimating the payoffs

This is the most crucial & interesting part and we will take the assumptions based on publicly available news bytes.

Option 1

Bank: Normal NPA Resolution Process

Corporates: Stall the process

Payoff for the banks (X1): Full loss recognition, write-offs or at best delayed provisioning

Payoff for the corporates (Y1): Rank 1. Good prognosis as it avoids payment though future financing will be in question, impacts growth potential. Also, this outcome can be due to potential collusion with bank

Option 2

Bank: Invoke Bankruptcy

Corporates: Stall the process

Payoff for the banks (X2): 30-35% recovery of debt amount. News reports are estimating 50-60% haircut that the banks must take even if the bankruptcy proceedings go well. This is because significant part of these loans (e.g. working capital loans) are not backed by fixed assets and hence may not be recoverable. Also, knowing that minimum 270 days’ period for NCLT process and potential litigations post that with NCLAT & higher courts, the actual process may be higher & hence the net NPV of the recovery can be expected to be somewhere between 30-35 % of the total debt. Again, the bank must bear the litigation cost as well

Payoff for the corporates (Y2): Rank 4. Worst as bankruptcy will mean winding off & losing of on possible recovery after economy improves.

Option 3

Bank: Normal NPA resolution process

Corporates: Pay & resolve

Payoff for the banks (X3): 60-70% recovery: Lesser haircut, faster normalization, lesser overhead on bank

Payoff for the corporates (Y3): Rank 2. Ability to leave the past, secure investments and focus on turning profitable though comes with parting away capital to repay debt or raising capital through other costlier means to pay off bank

Option 4

Bank: Invoke Bankruptcy

Corporates: Pay & resolve

Payoff for the banks (X4): 40-50% recovery: Considering that bank will be too eager to minimize loss & resolve fast. Hence haircut will be high but will save on time & cost which adds up to the net recovery

Payoff for the corporates (Y4): Rank 3. Average: Inclusion of 3rd party (NCLT) may reduce leverage of corporate, bad noises, brand impact and loss of credibility which may impact future capital raise

Key outcomes:

  1. No dominant strategy for the banks
  2. Neither there is a dominant strategy for the corporates.
  3. The best strategy that works out is for banks to follow normal process of NPA resolution and the defaulting corporates paying up!

The last point (#3) looks very counterintuitive! Else how can we explain why the #3 has not worked out till date and we agree that failure of this was the biggest driver for the NPA ordinance. This is where the NPA ordinance has brought in the change.

Earlier, the empowerment of new Sec 35AA was missing i.e. empowerment to proceed with insolvency for these defaulters. Under that condition, the best option for Defaulters was to simply STALL and that’s exactly what they were doing! With empowerment of the banks, the equation changes. If the defaulters continue to cheat (STALL), the bank’s best option will be to file bankruptcy and that creates WORST payoff for the defaulters. This then makes the ‘Pay up & resolve’ a much better strategic choice for the corporates.

To conclude, we feel that the promulgation of Sec 35AA has turned the game upside down and now makes it more lucrative for the defaulters to pay up. Hence in next few months, we can expect more defaulters quickly resolving the debt issue with the banks! This off course can go for a toss if with time it becomes evident that the bankruptcy proceedings are not successful!

Pls. note that the author is no expert on game theory and above is only an amateurish experimentation of the theory to get a deeper understanding of the strategic options & expected payoffs under such a condition. We will be very happy to receive constructive criticism, including errors/ omission and different opinions to initiate a healthy discussion!

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